Pl
RU
The amendments to Section 174 have been in effect for several years, yet many companies still struggle to fully understand how to properly account for R&D expenses incurred outside the United States. These changes have presented significant challenges for international businesses. Previously, such expenses could be deducted immediately, simplifying tax reporting and reducing taxable income. However, they must now be capitalized and amortized over 15 years.
In practice, this results in additional complexities in reporting. Companies face the need to file extra forms, such as Form 3115 to reflect changes in the method of accounting for R&D expenses and Form 4562 for depreciation of capitalized costs.
Incorrect allocation of these expenses can not only distort financial results but also lead to tax risks and audits by the IRS. For instance, if capitalizable costs are mistakenly expensed immediately, it artificially inflates expenses and reduces profit, which may be viewed by tax authorities as an attempt to conceal income. Conversely, misclassifying expenses that could have been deducted immediately will overstate assets, thereby increasing payable taxes. Therefore, a thorough analysis of each cost category is critical to ensure compliance with tax regulations and the accuracy of financial reporting.
Our team has helped numerous clients navigate these challenges and establish proper accounting practices. One such case involved an American company working with Polish developers. To resolve the issue, we undertook a comprehensive review of their documents, organized the data, and ensured accurate reporting within the required timeframe.
Case Description
An American company registered in Delaware faced a common challenge for international IT businesses: tax accounting for intellectual property created by foreign contractors.
A Polish team of 50 sole proprietors provided services throughout 2022 and 2023, regularly invoicing the American company for their work. However, changes in U.S. tax legislation (Section 174) required a new approach to accounting for these expenses.
The amendment mandates that R&D expenses incurred outside the United States must now be capitalized and amortized over 15 years. This came as a surprise to the client, as such expenses were previously deductible in full immediately.
Task
Our assignment involved:
- Analyzing the costs incurred by the Polish contractors during 2023.
- Categorizing these costs into two groups: those eligible for immediate deduction and those requiring capitalization.
- Ensuring compliance with U.S. tax laws while considering the specific taxation rules applicable to the Polish contractors.
This project required a detailed review of all submitted documents, including contracts, invoices, and work completion records. Many invoices contained vague descriptions such as “programming services,” which did not clearly define the nature of the work performed. We conducted additional discussions with the contractors to clarify the details of each expense and make well-informed decisions.
Solution and Outcome
Despite tight deadlines (only two weeks before the October 15, 2023, filing deadline), our team swiftly allocated resources and completed the project on time. As a result:
- The client’s expenses were accurately categorized as either deductible or capitalizable, ensuring compliance with tax obligations.
- We successfully managed to significantly reduce the capitalizable costs, which notably lowered the client’s tax burden. To maintain confidentiality, let’s use a simplified example to illustrate what this might look like in numbers.
Imagine the total development expenses amounted to $1 million. If the entire amount had been capitalized, these costs wouldn’t have been deductible for profit tax purposes, resulting in an additional tax liability of $210,000. However, through a detailed analysis and careful review, we identified that only $300,000 needed to be capitalized, while the remaining $700,000 could be deducted as current expenses. This adjustment reduced the taxable base, ultimately lowering the profit tax by $147,000.
- The financial reports were prepared in accordance with the requirements of both parties, avoiding potential tax risks and penalties.
Conclusions and Recommendations
This case highlights the importance of timely and detailed expense tracking in international markets. The amendments to Section 174 pose a significant challenge for companies that have not yet adapted to the new rules. It is essential to consider both the tax regulations of the client’s country and the taxation specifics of their contractors to avoid discrepancies and financial losses.
At SMAR, we have extensive experience in handling such tasks. We know how to effectively manage tax risks, streamline accounting processes, and develop financial strategies tailored to the complexities of international operations. If you need assistance with tax accounting or financial management, our team is ready to provide expert solutions for your business.
